The Dollar Nears a Crucial Level -- For All Markets

CURRENCIES FROM ALL POINTS OF THE GLOBE are making new highs while the dollar is setting lows. A distinction without difference? Maybe not.

As expected, the British pound moved above $2 Tuesday for the first time since it was forcibly ejected from the European Exchange Rate Mechanism in 1992. The euro, the successor to the ERM, traded just $1.3670, its record since coming into existence in 1999. Down Under, the Australian dollar traded as high as 83.85 cents, the highest since 1990, while the New Zealand dollar at 74.78, a 22-year peak.

Those exchange rates versus the dollar get most of the media attention but forex mavens are keeping an even closer eye on the U.S. Dollar Index, which measures the greenback's value against a basket of major currencies. The Dollar Index doesn't exactly get the notice of the Dow but it reflects the U.S. currency's broad trends, not just moves against a particular currency. (The euro accounts for more than half of the index, followed by the Japanese yen, the pound, the Canadian dollar, with pinches of the Swedish krona and Swiss franc thrown in.)

In any case, the Dollar Index closed Tuesday at a two-year low of 81.75. But even more importantly, the index is nearing 80, a level that has been reached four times since 1990 -- and has held. You don't have to be a believer in technical analysis to think the 80 mark is significant.

As Charles Dow, the father of Dow Theory explained it, markets resemble tides; place a stick at low ebb and another at the high tide to the track the market. For the Dollar Index, its low-water mark of 80 has held since George H.W. Bush was in the White House. It's now approaching that mark for the second time in George W.'s presidency.

To hold that line, however, has taken the equivalent of tons of sandbags in the form of massive dollar purchases by foreign central banks, notably the Peoples Bank of China. In the first quarter alone, China's central bank bought $136 billion -- the equivalent of $1 million a minute, the Financial Times points out. That brought China's currency reserves to $1.2 trillion, with a "t." Indeed, the biggest U.S. import from China isn't products but cash, contends Joseph Quinlan, chief market strategist for Bank of America's Investment Strategies Group.

That central-bank buying has helped to damp the dollar's decline, writes Jason Rotenberg of Bridgewater Associates, a leading institutional money-manager. "With the dollar not be allowed to move enough to clear private transactions, China's reserve accumulation is one place where you can see how ugly the dollar's true economics are," he adds.

Yet holding that line has been crucial for the world's markets. Those dollars mopped up by the world's central banks get recycled back into the credit markets, holding down interest rates and providing the billions for everything for the federal deficit, corporate buyouts to subprime mortgages.

"The entire global liquidity dynamic now rests on a stable/strong dollar," writes Stephanie Pomboy, head of the MacroMavens advisory. In addition to foreign-central-bank buying, the buck's been bolstered by the Federal Reserve holding its target rate for federal funds at 5.25%, far above other major central banks' official rates, especially the Bank of Japan's 0.5%.

That may have some counterintuitive implications for the Fed.

"Time was, when concerns about pissing off speculators and foreign central banks wouldn't have entered the Fed's decision-making process," Pomboy continues. "Today, however, these folks have usurped the responsibility for the credit creation process from banks over which the Fed has direct control. With the dollar forming the lynchpin of the global credit dynamic, the Fed finds itself in the paradoxical situation whereby rate hikes can arguably ease credit conditions...while rate cuts could tighten them!"

The course of the global markets will depend importantly on the dollar. So far, the 80 mark on the Dollar Index has held. Will it provide resistance? Or will it be its Maginot Line?

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